Anthropology, the organizing theme of the current series of postings, is an extensive discipline with many specialties. It also intersects with other social sciences, including sociology and economics, which is evident when studying the investment industry and the organizations within it.
The culture of any one organization is unique, but the differences among organizations that have similar legal structures, mandates, and strategies tend to be minor. Many organizations claim that they are different from their brethren, but the social pressure to play the game as it is played by others is powerful. Commonality also extends from organizations to individuals, as investment roles generally hew to a few archetypes.
In studying culture in the investment ecosystem, you can analyze individual organizations, groups of them, the roles therein, or the beliefs of the industry writ large.
All of those levels come into play when considering what is perhaps the most pervasive issue of investment belief and practice across the industry today.
Communities of practice
In “Active fund managers and the rise of Passive investing,” a paper by Yuval Millo, Crawford Spence, and James Valentine, the authors use a “communities of practice” framework:
Communities of practice are conventionally defined as groups of people informally bound together by shared expertise and passion for a joint enterprise, who regularly interact to learn or improve their practice.
We suggest that financial markets should be understood as characterised by slowly evolving communities of practice whose habits, routines and ways of knowing can be difficult to shift, even when faced with overwhelming evidence that what they are doing doesn’t work most of the time.
The paper examines the effects on practitioners resulting from the move “from one investment dominant mode to another” in the industry over recent decades:
The shift from Active to Passive investment is reflective of deeper changes in financial markets, implying a new nexus of social structures, new practices, and different bodies of knowledge.
(A 2022 posting, “We Need Some New Terminology (Part 2),” addressed the problematic use of the terms “active” and “passive,” especially the use of “passive” to describe not just broad, market-weighted beta as it originally did, but also “indexed” strategies that don’t fit that model. The authors use the term “robotisized ETFs” for those indexed strategies and also reference “algorithmic trading,” yet another category. As in the paper, “passive” below refers to all of the above as a catch-all non-active description, despite the shortcomings of that approach.)
The growth of passive and the change in industry dynamics have spawned a variety of reactions from those who invest actively. Similar situations outside of the investment world have been studied before. What are the typical effects on communities of practice when that occurs? According to other researchers, as summarized in the paper (citations removed):
The literature on communities of practice suggests several reactions from incumbents when such fundamental challenges to legitimacy are raised. One reaction entails asserting a strong identity, which can rally previously disparate members of a community together and offer a renewed sense of purpose. Another defensive manoeuvre is to delegitimize non-members’ knowledge and establish boundaries between “us” and “them.” Finally, communities can also defend their existing field position by making a practice inaccessible to others, perhaps by inscribing their worldviews into particular artefacts or practices.
The goal of the paper was to see if those kinds of actions are prevalent among active managers.
Methodology
The authors interviewed 69 investment professionals, split between the buy-side (analysts and portfolio managers) and sell-side analysts, together representing “a core section of the Active fund management industry.” Those interviewed on the buy-side favored fundamental analysis and generally had portfolios of less than fifty stocks.
In the tradition of ethnography, the authors relied “on the language of the actors themselves, recognizing that the subjective interpretations of research subjects, even when self-serving, are rich resources for theory building.” Their road map was a standard one for this kind of work, using “descriptive, participant driven” ideas to form “conceptual, theory driven themes.” Illustrative quotes from interviewees are included.
Cognitive dissonance
Active managers know (as does everyone else) that as a class they do not outperform traditional passive strategies over time. Research studies show that active managers outperform on a gross basis but underperform after fees. Naturally, practitioners expect to be among the cohort of managers that do outperform, despite the odds against them.
As a result of that disconnect between expectations and reality,
self-belief in the Active investment community has been shown to be fragile. Fund managers tend to both believe and not believe that they can “beat the market,” and, relatedly, both believe and not believe in market efficiency. This is suggestive of a certain cognitive dissonance held by members of the Active investment community. The rise of Passive investing introduces an interesting dynamic to this epistemic tension. On one hand, the growing success of Passive strategies like index investing carries with it the premise that it is not possible to beat the market. As such, the conflict in the Active community between circumstance and belief intensifies, much in the way that it does when members of religious groups are faced with failed prophecies. However, in such circumstances, members of religious or other groups often tend to increase their commitment to their beliefs and even start to proselytize more vigorously.
In their interviews, the authors often discovered that many of those involved in active management voiced “a recognition of the merits of Passive investing coupled with a simultaneous defensive attachment” to their own beliefs. Many of them “almost sounded like advocates” for passive investing, with one sell-side analyst even saying, “All my own money is in index funds.”
When then asked why he or she participated in what appeared to be “a largely futile activity,” that analyst said, “I have an incredibly interesting job.” Another important reason for staying the course was summarized by a buy-side analyst: “I have to have that view [i.e., Active investing adds value] because of the living that I have.”
Defensive rationales
Interviewees also cited “how Active fund management is, in their view, still ultimately superior to Passive investing.” Elements of that argument include:
~ Passive doesn’t factor in everything:
Collecting information and generating interpretations through face-to-face interactions are presented as highly valuable and irreplaceable, both due to differences in the availability of information (“access”), but also due to information discovery (“meet people they would have otherwise never known”).
~ That’s particularly true in specialized areas, as with research into whether a drug would pass regulatory muster:
Predicting whether or not the therapy would be approved by the regulator was something that, we were told, required in-depth industry knowledge that “no electronic trader could pick up.”
~ “Price discovery” is the province of those doing active management and therefore is preeminent among investment activities.
~ Passive only does well in certain kinds of markets. (However, those assertions are “not supported in recent findings.”)
~ There was a general belief in “the advantages of human over machine-driven analysis.” (The research was conducted well before the current excitement over the application of artificial intelligence in investment decision making; a follow-up study that explores how views on that front have changed would be fascinating.)
~ British interviewees in particular stressed that passive strategies do not effectively take into account the shifting nature of ESG performance by companies.
~ A popular refrain was that the growth in passive is making active management an even more attractive activity, that fewer players looking to capture inefficiencies would make returns better for those who remained. One interviewee welcomed the trend “as it presented him with ‘more lambs to the slaughter.’ ”
Market effects
As they defended their position, active managers discussed the significant effects of the rise of passive strategies on their work. They often viewed the changing dynamics as a blessing:
The Active worldview proclaims that markets reveal the fundamental value of assets through their operation. This, however, may happen only if actors who follow fundamental value principles dominate trading. When such actors do not play a dominant role, prices deviate from their intrinsic value. Such deviations, though, can serve as opportunities.
However, that trading is “changing the causality in financial markets, thus making Active analysis less relevant.” Along with the “existential threat that a growing market share of Passive funds constitutes, this creates a double whammy for the Active community.”
Real active or faux active?
Just as descriptions of passive, indexed, and algorithmic strategies are used in imprecise ways throughout the industry, the term “active management” lumps a lot of different approaches together.
One way to divide the universe of managers is “between the general herd on the buy-side and an elite few.” Participants putting themselves in the latter group were quick to apply an “internal boundary” within the active community in addition to the external one erected versus passive investing. From one interviewee:
Steve Cohen is right when he says, “the industry has a massive lack of talent.” It’s just made up of very average people who just don’t know what they are doing.
But a better (or at least more charitable) way of describing the two categories of managers are those who play the game as it has always been played (we could call them traditional active managers) and those who adapt and innovate as conditions change.
Let’s take the old-game-players first. They try to generate alpha while working within tight limitations, they often lack resources, and their methods are unremarkable and undifferentiated. Most of the clients who hire and fire them don’t like “style drift” or tracking error — and a “consistent, repeatable process” is highly prized. Therefore it should not come as a shock that their world view is one of stasis:
By and large, Active community members had much faith in their own processes and were keen to highlight the importance of their training and the experience they had picked up over (in some cases) long periods of time in the investment world. In this respect, they continued to assert their identity as hypothesis-driven, relying on small data and bottom-up forms of analysis.
The authors believe that “the Active community is rather inactive about its own decline,” “is struggling to explain to itself what its purpose and utility are,” and engages in “hopeful fantasizing.” Those statements are supported by the publications from active managers and advocacy groups which rush to defend current practices instead of exploring ideas about how to improve them. Along those lines:
Rather than proactively outlining adaptation strategies, we found that interviewees engage in discursive boundary work that aims at justifying their doing the same things that they have always done. Among the 69 subjects interviewed, fewer than five mentioned any efforts by their firm or individually to adapt to this change through training or adopting new investment techniques.
What differentiates real active from faux active is a mindset that reflects the nature of markets and how they evolve — and the absolute necessity to bring originality to the effort on a continual basis. A cemented process and years of experience lose their relevancy over time — in a sense becoming passive themselves.
Applications
The most obvious application of the authors’ insights is for active managers to consider whether the implementation of their beliefs can truly result in alpha across time. If not, the hard work of changing the culture of an organization to an innovative one (and dragging existing clients along for the ride) lies ahead.
In the same way, others — asset owners, advisors, etc. — who use active management have to ask themselves whether the restrictions they put on active managers impede the alpha-creation process and whether they should revisit their assumptions about what manager characteristics increase the odds of good future performance.
Finally, for those who study the industry, its organizations, and its people, the authors write that “the communities of practice perspective advanced here can be applied to other groups of actors.” If you look around you’ll see conflicting forces of inertia and opportunism operating everywhere in the ecosystem.
Published: June 1, 2023
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